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Sep, 10 2010


THE debate on rentals has been quiet consistent over the past few years. As the commercial real estate property saw a boom, few questions have come to intrigue the franchise projects viability.

THE debate on rentals has been quiet consistent over the past few years. As the commercial real estate property saw a boom, few questions have come to intrigue the franchise projects viability. Let's discuss some key areas and corroborate them with a rich research database to reach a better understanding of the rental graph.

Recessionary dilemma of a franchisee

Only a few quarters back, the retail scenarios was in conflict with this ecosystem. The slowing sales were resulting in lower inventory turnover and increasing working capital requirements for retailers. This, in turn, had resulted in liquidity pressures for many retailers. To free the cash that has been locked, a large number of companies had been trying to reduce the inventory and the cost elements on their books and shorten the working capital cycles. Franchisee invests a considerable amount of money as initial capex. This, along with the need for regular working capital, royalty payments and marketing expenses, leave him cash deprived. Treading consumption pattern led the optimistic sales forecast fall flat. The only logic surpassing all tactical measures was to reduce the cost and reduce the overheads.

Any franchise manager must ask himself the following critical questions while deciding on project viability.

Will the present rentals sustain tough times?

Major contributor to a small retailers' cost, which should ideally for 25 per cent of sales in case of a small store are rent (10 per cent), power (2 per cent), staff (4 per cent), marketing (4 per cent). Real estate location is a strategic decision in case of retail expansion. It becomes more critical when the company decides to go for a low-cost expansion through franchising. Quite frequently, it is seen that rental cost is ignored by the franchisors, as they take the assumption for granted that high rental locations will ensure higher sales.

High footfall location, which promises higher sales, come at a price, which is as high as 20 per cent of the sales, questioning the robustness of the project to sustain tough times, which might cause a skewed liquidity trouble for the franchisee. Experts believe that if the rental cost is less that 10 per cent of the sales, in a realistic scenario will lead to realising profitability for a franchisee. Prohibitive rental cost will create hassles in realising RoI. Even though the rental cost distribution over revenues will eventually come down as the franchise unit starts growing in terms of sales, yet the franchisee must prepare to sail through the pessimist phase.

Would the rentals intensify brand equity in long term?

Long-term sustainability as well viability of a catchment must be borne in mind while evaluating the project viability. A store at a prime location, which ensures high footfall apart from anything else, promises million dollar visibility to the brand. Most of the retailers benchmark their competitors' sales while evaluating any location. At the same time, due to development of a retail cluster, with presence of all the major player of that category, a particular retail catchment becomes more attractive. In case of national brands, the investment in brand development is higher so the overall recall value can help in setting off the rental cost. In other words, if a brand has an established consumer base and identity, then a low rental location can be considered due to the correlated consumer behaviour.

Will it be the perfect locationfranchise partner combination?

To overcome the problem of higher rentals, Indian franchisors have wanted franchisees to own the property to increase project viability. When a brand wants to be at a particular high street owing to peer pressure, he will choose a franchise partner, who owns the space in that location. This priority will be higher than any other parameter.

For franchisee or the property owner, it's an attractive preposition as the present real estate scenario in India suggests 8-10 per cent returns on a commercial property, whereas the cost of owning the property is much higher than this. A typical franchise model ensures at least 15 per cent Returns on Investment. Franchise contract, however, is about sharing the entrepreneurial risk and responsibilities. Many franchisors have burnt their fingers and faced closures in spite of the right choice of location simply due to wrong choice of the franchise partner. So, the point is not how much rent you pay, but how you bring down the contribution of this cost by leveraging on the revenue growth. Many rental spaces in malls are owned by investors, so calibrating retailers' sensibilities becomes difficult for them.

Will rentals justify the marketing cost?

Internationally, franchisors have risen above hefty franchise units. Their focus now is on increasing advertising (29%), growing their existing client base (24%), improving productivity (21%) and reducing prices (15%). Those experiencing difficult trading conditions are looking to grow existing clients and targetting new ones, but the focus is much more on reducing business overheads. The conflict, of course, arises when a low-cost upcoming location is chosen to reduce the rental cost burden. The marketing, advertising and above-the-line marketing expenses ensure enough footfalls, which could be converted into sales. Thus, marketing cost to sales again makes the project viability prohibitive. For example, incremental marketing expenses, say 10 per cent of the gross revenues, are bound to increase as the business grows, compared to a 5 per cent inflationary increase in the rental cost. This is a greater financial liability for the franchisee. A good costly location at least ensures concept visibility and presence of brands when benchmarked with competitors.

McDonald's location turnaround

This goes back to time when McDonald's, the most admired franchisor at that time, was struggling to make the business profitable. They were not bringing in enough revenue from their franchised restaurants. Part of their trouble was in getting the funds to pay for the land and building of the restaurant. In order to maintain control over operations, the company needed to franchise one store at a time, rather than a whole slew of stores over a particular geographic zone, which is what other food chains were doing. Although other chains could attract big investors, the franchisees McDonald's attracted didn't had the funds to pay for the land and the building. That all changed in 1956 when the company decided that the real money was in real estate. McDonald's leased a plot of land and the building for each restaurant. It then sub-leased to the franchisee, who would run the restaurant. They further developed a plan to eventually take out mortgages to own both the building and the land. They soon established the Franchise Realty Corp to find willing landowners. Initially, McDonald's charged franchisees mark-ups of 20 per cent of the lease costs, but it eventually increased this to 40 per cent. Franchisees were responsible for insurance and taxes, ensuring a steady profit for the company as long as the restaurant stayed in business.

The rent amount could have been even more if the restaurant was doing well. The franchisee had to pay either the stipulated lease mark-up or 5 per cent of the sales, whichever was higher. The upfront security deposits from the franchisees would fund the opening of more restaurants. Overall, this created a symbiotic relationship between the franchisee and the company. McDonald's Corp had a vested interest in the ongoing success of its individual.

Concluding chicken or the egg dilemma

While assuming that there are differences in the quality of locations with regards to their potential profitability, a franchisee, in securing a franchise contract, is guaranteed a return that exceeds his opportunity cost. The theory of franchise locations, which is applicable in international markets, states that franchisors will open company-owned stores at more profitable locations while leaving the less profitable ones for franchised outlets. Similar trend is evolving in the Indian franchising in order to set off the high cost of operation at key locations. This preposition assumes that franchisees need to be equally enterprising and supportive in order to make a franchise unit successful.

The question bogging down Indian franchisors is what comes first, the location or the franchisee. The turbulent and unpredictable market signals that the franchisor must infuse resources in developing the right location while making this process independent of the franchisee recruitment.

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